Invest offshore with structured notes

by Aaron A Day on February 5, 2013

There are essentially 3 financial instruments involved in the make-up of a structured note

Part 1 – to provide the capital security at the end of the 3 year term:

A zero coupon bond (A bond) is bought by Bank to provide the 100 return in 4 years time. This will redeem at 100 in 4 years time and sufficient is bought to provide a return of capital to investors. For example, if the bond was yielding 5% pa now, it would cost 80 for a 4 year bond returning 100 upon maturity.

Part 2 – put option sold for 15 to someone else:

A put option is sold. This give the buyer of the option the right to sell the worst performing share at the original strike price if the price of any of the shares falls by more than -50% from their strike price at maturity of the product.

By combining this with the zero coupon bond above, we achieve the soft capital protection. The option buyer will pay a premium, likely to be in the order of 15%.

So, the Bank will have received 115 thus far = 100 from investors (Part 1) and 15 from the put option buyer (Part 2).

Part 3 – the Bank pays for a 4 year income providing annuity to provide the annual income:

As mentioned, the investor pays 100 (Part 1) and there is 15 from the sale of the option (Part 2) giving a total of 115.

If we assume 5% cost and charges then we have spent 80 (bond, part 1) + 5 (charges) =
85 spent to cover expenses and create the soft protection.

The balance of 25 (115 – 85) is used to buy a bond that has the characteristics of a temporary annuity for 4 years, repaying the initial capital of 25 plus interest over the life of the product to give the clients the 8.5% annual return.

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